Nordea AM: 'The China Deal is Coming'

January 15, 2019

By Sébastien Galy - Senior Macro Strategist

By Sébastien Galy - Senior Macro Strategist

As we enter 2019, many investors are eager to put 2018 in the rearview mirror for good. But the US trade deal (or trade war, depending on your perspective) with China continues. Irrespective of your opinion, strip away the rhetoric surrounding Donald Trump and you find a savvy American president who understands his electorate and prevails with an incredibly narrow base equivalent to roughly a quarter of the US population. With a large and persistent trade deficit and an aggressive style, he is likely to succeed in forcing China into a favorable trade deal. The current government shutdown negotiations are a good indication of what we will see with China. The odds are that negotiations will take up to a month before the economic toll becomes a problem for his Republican base. Economic activity is damaged by the process but ultimately Trump will get partly what he wants as the vast majority of government employees are Democrats. Likewise, it’s not improbable we could be looking at a trade deal with China around September, late enough to still have an impact on the Republican primary debates.

What does this mean for investments?

The probability of a late China deal affects our asset allocation by benefiting Emerging Market (EM) debt and equity, as well as European and US equities given their exposure, starting at some point in Q1. This should be triggered by two events: first, the realization that a China deal is virtually a certainty and second, when the market stops reacting to negative news from China. While professional investors realize that official data plays some catch-up to events on the ground, retail is surprised. Furthermore, China is likely to be the leading motive to explain missed earnings as were previous themes such as inadequate currency hedging. Having said that, bottom-up earnings are likely to show the China impact and higher input costs. Until then, we remain in a difficult environment with volatile equities and underperformance until we reach this kinking point largely determined by China.

We remain positive on low volatility equity, as well as risk premia investing or long-short strategies. Why? A bad year for equities in 2018 has built a base for 2019.

Earnings growth peaked and lost steam in 2018 with 2019 forward guidance down on the back of an expected slowdown and higher input costs. Retail is yet to price this fully relative to the China factor. This is reflected in a large fall in P/E combined with lower asset prices. Consequently, this is building good intrinsic value especially for lower risk equities.

Volatility spiked at the end of 2018 amid low volume and should stay elevated.

Volatility spiked up to 36%, levels comparable to 2011, 2015 ..., and we forecast an elevated level or mid regime of 12%-25% for 2019 driven by lower growth and large leverage in the High Yield space with likely rising default risk as well as political risks. One key factor is that the Fed has been tightening, though this may stop in 2019 against a Fed forecast of two more hikes. This means that equities with a lower volatile profile might be in favor in 2019 along with some moderate selectivity/management in EM once a China deal starts to be priced in. Beginning of 2019, it will be interesting to see how asset allocators position themselves. This typically leads to a trend that is squeezed a few months down the road. As of now, long EM seems to be a common theme given cheap valuations, high yields and hopes of a China trade deal.

There doesn’t seem to be a market consensus concerning a recession in the short to medium term. Thus, lower risk and lower beta stocks and/or outcome solutions, such as risk premia investing or long-short strategies, might be favored.

In the bond market, we prefer EM, EU to US High Yield, while EU debt for US investors is attractive.

High Yield spreads spiked at year end creating some value in junk bonds with predicted low defaults, however:

The cost of currency hedging in EUR/USD spiked to historical highs of more than 300bps:

The upcoming China deal

China and the US reached a ceasefire on the 90-day deadline after China promised to buy a very substantial amount of US goods, all good intentions while Soybean imports completely collapsed. Both China and the US know that the deal needs to support the US President’s 2020 bid. The end date is likely Q3 as the first debate will be starting by year end and the first primaries are in February 2020. From a bargaining point of view, the US has given the list of what it wants and the Chinese are slowly starting to do the same. The negotiations then typically diverge before rapidly converging at the close. The trick therefore is to find the likely date of completion and in particular, the moment when the market will start to consider that it is a done deal and only a matter of time – Q1 2020 by our guess.